Economics

The world is suffering from global recession, high unemployment and increasing inequality. Before policymakers can even begin to address these issues, they must first understand the causes. Consciously or otherwise, economic theory is always in the policymaking background somewhere. Of course, policymakers already have their theories, but if the theories are wrong, then policies based on them are probably wrong too. This post critically reviews the principal mainstream economic theories and their associated policies, highlights their weaknesses and provides reasoned alternatives.

Mainstream Economics

 

All theories start from self-evident axioms and proceed via chains of inferences to conclusions. Economic theory is no different. Robert Skidelsky argues that the principal theories underlying mainstream economics are:

• Rational expectations theory: apart from normally distributed errors, the future, statistically, will be just like the past
• Efficient markets theory: markets always embody all the information rational economic decision makers need to know
• Real business cycle theory: markets are always either at, or heading toward, their optimum. Hence only external shocks can disturb them.  

And Paul Davidson argues that the key axioms underlying these theories are the:

• Utility maximising axiom: consumers and producers will always spend all their incomes, and will always change their patterns of consumption in response to relative price changes. This means that markets will always clear. Hence unemployment and surplus or deficit products are impossible.   

·         Gross substitution axiom: Every product is a gross substitute for every other product, which implies that adjustments in relative prices will always clear all markets.

·         Neutral money axiom: Money does not affect ‘real’ things. Money is just a means of exchange which solves the difficulties of barter. This result implies that governments cannot spend their way out of recessions; the attempt to do so will just accelerate inflation.

·         Ergodic axiom: The future is just a statistical reflection of the past, so decision makers can accurately calculate their risks based on estimated future probabilities.

• Say’s law: The French economist Say believed that supply creates its own demand. Crudely: employers make products and pay incomes to themselves and their workers who both then in turn spend their money on the products they have made.

Paul Davidson on Alternative Explanations

Market Forces

 

In mainstream economics, the market always knows best. Market prices, when established by unconstrained supply and demand, are true and accurate bearers of the fundamental information that decision makers need to know to make rational decisions. Forces external to the market are the only causes of market disturbances; forces such as natural disasters or sun spots or inappropriate government intervention which only serve to deflect equilibrium prices momentarily from their optimum levels.

 

Consequently, economic policy should seek to limit anything which might shift the market away from its optimum. For example, if unions negotiate increased wages, the market will simply force employers to cut production because of reduced competitiveness and sales. This decline will lead to layoffs and higher unemployment. Mainstream economic theory argues that the rational thing to do would be to lower the wage rate so that labour can again become competitive. Otherwise, market forces will achieve this outcome by increasing unemployment; thereby forcing workers to lower their wage rates as they compete with each other for the available jobs. According to the mainstream, neither the government nor anyone else can forever constrain market forces. In the long run, they will always prevail.

 

This lack of constraint is also true of financial and international markets. Market forces now set interest rates and exchange rates. These rates were once critical levers of economic management, but neo-liberal governments defer to market forces and no longer set them. The Central Bank, also independent of government, has the primary goal of keeping inflation low by manipulating interest rates irrespective of unemployment levels. It no longer has the job of controlling money and credit, since control of the money supply, in deregulated financial markets, is virtually impossible in any event.

For the last three decades, these neo-liberal ideas have set the parameters for economic management in most OECD countries – Australia included.

Keynes and Liquidity Preference

 

These theories all suffer from one manifest weakness. They are demonstrably wrong – and obviously so in the light of the Global Financial Crisis. In 1936, John Maynard Keynes published his General Theory of Employment, Money and Interest. Keynes did not reject market theory; he simply believed it irrelevant when set against the bigger issues of full employment, income distribution and international trade. Keynes argued that the future is not only unknown but also unknowable. Consequently, the future is genuinely uncertain, not just probabilistically uncertain (i.e. the future is not random variations around known normal distributions with known and stable standard deviations). But individuals and organisations have commitments and obligations, often legally enforceable, which they must meet irrespective of the prevailing economic circumstances As a result, they take out insurance against this uncertainty by acquiring and holding liquid assets; and the higher the uncertainty, the higher the liquidity preference. This response to uncertainty removes effective demand from the economy, and as the level of effective demand falls so too do sales and consequently employment.

Savers can hold onto their savings or they can place them in banks to be available for borrowing for investment. But if corporations are not investing for the same reasons that savers are not spending – uncertainty about the future – then the savings will lie unutilised in the bank vaults. Banks might attempt to lower interest rates to encourage investment and discourage saving, but again under conditions of uncertainty about the future, this tactic is unlikely to work. Given these circumstances, according to Keynes, liquidity preference dominates consumer behaviour. And this drive for liquidity causes persistent unemployment.

Money, therefore, is not neutral. Liquidity preference withdraws money (effective demand) from the circular flow of income and expenditure and, consequently, unemployment will rise as spending falls. This means that Governments can step in to offset liquidity preference and increase spending on goods and services without worrying too much about budget deficits. Government spending is ultimately self-financing because it raises income and employment levels thereby reducing expenditure on unemployment benefits and increasing government income and expenditure tax revenues.

 

Paul Davidson on INET

Globalisation

 

On a global scale, theories of unregulated markets have laid waste to huge swathes of the developing and developed world via the mechanism of globalisation. The mainstream policy of international trade - Globalisation - rests on the theory of international trade known as the theory of comparative advantage.  This theory claims that if

·         national boundaries constrain local capital and labour, and

·         nations produce in those industries where they have a relative advantage because of large deposits of natural resources for example, and

·         the world market buys all the extra product,

Then everyone will have more products and higher incomes. This theoretical conclusion is true even if some countries have an absolute cost advantage in all products because of factors such low wages, child labour and poor working conditions.

In practice, this rather fanciful theory invariably fails to satisfy any of the above conditions. In a world dominated by unregulated, globally mobile capital and multinational corporations, low-wage countries will attract the bulk of foreign investment because of their low wages. In these cases, productivity depends more on the efficiencies embodied in the manufacturing technologies used, than on any advantages from local resource or labour endowments. The cost advantage does not stem from any natural relative advantage. It stems instead from a social and economic absolute advantage brought about by low wages and poor conditions - child labour, absence of safety and absence of environmental regulations. Multinationals, setting up with the latest manufacturing technologies in low-wage countries, have an absolute cost advantage over their competitors. An advantage based solely on low wages and poor conditions. Mainstream international trade policy - Globalisation - simply boils down to low-wage countries driven by poverty forcing high wage countries to export jobs; a global race to the bottom in which the rich always get richer by continually eroding worker’s pay and conditions.

 

Robert Skidelsky on the Crisis of Capitalism

The Global Financial Crisis

 

In 2007-08, the global financial crisis plunged the world economy into the greatest economic collapse since the Great Depression. And, similar to the Great Depression, an unrestrained credit bubble produced the latest collapse; a credit bubble which quickly grew out of control, burst and brought the global economy to its knees.

The Great Depression followed on from the ‘Roaring Twenties’, a period also of unrestrained credit growth inflating a growing stock market bubble which finally burst in 1929. In the years that followed, the Roosevelt Administration introduced a battery of banking regulations designed to prevent such events from ever happening again. But, over the last three decades, successive US governments have repealed the Roosevelt regulations. In the late 1990’s, President Clinton repealed arguably the most important of the Roosevelt banking regulations - the Glass-Steagall Act of 1933. This deregulation paved the way for a repeat of 1929.

 

Following unrestrained credit growth through the first half of the 2000s and extensive financial market deregulation throughout the 1980-90s, the latest collapse occurred in 2007-8. According to the US Department of Homeland Security Senate enquiry, irresponsible lending, regulatory negligence, ratings agency failure and severe conflicts of interest in investment banking caused the collapse. Some investment banks were financially betting billions that the sub-prime stock they were selling to clients (governments, pension funds and other major institutional investors) would fail. The immediate losses amount to around ten trillion dollars in asset values, millions of jobs and millions of homeless brought about by foreclosures involving families unable to meet their mortgage commitments. We are still a long way from assessing the full global costs of this failed theory.

Mainstream economic theory and policy have failed miserably. Shareholders have lost trillions; workers around the world, but especially in the US, have lost their jobs, their homes and their pensions. On the other hand, some investment banks on Wall Street, such as Goldman Sachs, have done quite nicely, so do not expect the system to change any time soon.